A Case for an Alternative to the US Treasury Ladder

What happens when Money Market rates dip or rolling US Treasuries becomes much less lucrative?  

The answer or solution too many investors have is to ignore their core risk profile by simply increasing their allocation to equities.  Sometimes this is accompanied by mental gymnastics like: “dividend stocks are less volatile” or “value over growth.”

We don’t think anybody should be considering significant reallocations away from fixed income.  Most clients will already have Munis as part of their portfolio but many others may have turned their back to Corporate Bonds in favor of the risk-free alternative at elevated yields for the first time in decades.   It’s time to revisit this stance if you’ve taken it.

There are few key reasons we feel comfortable taking on credit risk at this time – that is to say, investing in Corporate Bonds versus merely staying in UST.  

First, let’s look at performance.  The US Aggregate Bond Index is designed to provide broad US coverage of the investment-grade US fixed income market by drawing its constituents from major fixed income asset classes: US Treasuries, US Agencies, Munis, Investment-grade Corps, etc.  

Over nearly three decades of annual returns for the US Aggregate Bond Index, only 4 negative years are registered, 3/4 of which are below 3% – in absolute terms.  As an asset class, bonds have been fairly stable despite Fed cycles or default rates in Munis and Corporate Bonds.

Second, we want to analyze principal protection.  Default rates for the highest quality credits are at extremely low levels versus historical averages.  In absolute terms, only 1.9% of “A” rated issuers have defaulted over any 10-yr period since 1970.  That means only approx. 2 of every 100 companies defaulted in any rolling 10-yr cycle.  This also highlights how balance sheets don’t materially deteriorate from one moment to another.  It is extremely unlikely a top rated credit will fall from grace over any 10-yr period.

In contrast, the highest rung of High Yield bonds (rated “BB”) has posted an average annual default rate of 0.72% over the past 25 years.  Which is to say, less than 1 of every 100 companies (issuers) in the space defaults per year.

Finally, as we all know “past performance is not indicative of future results”. So what does the current climate indicate? 

It is widely understood that companies have had access to capital markets and many have issued bonds in very favorable interest rate environments pre Fed hike.  What may be less understood is the quality of the companies bringing bond issues to market.  In fact, the share of the HG market composed of “BBB” rated bonds (lowest rung of the HG segment) has lowered, from the recent peak recorded 5 years ago (51%>>47%) – See Chart.  

Also, the overall share of the new issuance of higher rated bonds has risen significantly over the last thirteen years – See Chart.  

Whether this reflects the increasing health of companies in general or simply lack of market access of poor performers, is irrelevant.  These are two facets of current market conditions that denote the relative quality of companies tapping the market.  Which translates to the quality of companies backing the bonds that are available in the secondary market.  From an investor’s point of view, this is a positive signal that highlights the quality of portfolios that are on offer.  Which is to say, investors are able to construct portfolios drawing from a universe of fixed income securities that offer higher levels of comfort – from both historical and present perspectives.

Takeaways

• Extend duration (i.e., average maturity of bond basket). Most people rolling treasuries have worked with a sweet spot of 0-18 months where the yield curve was humped. This section maximized yields on offer. As yields go down, we think we should set our sights further out to 4-6 years.
• Add credit risk. US Treasuries are the de facto risk-free security. They remain a solid tool for the bucket one allocates to liquidity. For example, the heuristic that suggests a household have 6-9 months of budget on hand in liquidity (should a partner lose a job or have a disability) could be a good place for US Treasuries. But beyond that, the figures above show that adding credit risk to a core fixed-income portfolio has a good risk-return profile and should be considered.
• Some portfolios could even consider going further into the deep end with exposure to High Yield – the upper echelon, specifically. But this should be gauged depending on client risk appetite on a case-by-case basis.

Disclosures:
The information contained in this newsletter is provided for informational purposes only, and should not be construed as investment advice or a recommendation to purchase or sell a security. Investing involves the risk of loss that clients must be prepared to bear. This document contains forward-looking statements of opinion, belief, and expectation about the future. Actual results could differ materially from such statements and our opinions are subject to change without notice.